An Investigation of Bargaining Power in Mergers and Acquisitions

60 Pages·2014·2.15 MB·English

STOCKHOLM SCHOOL OF ECONOMICS
MASTER THESIS IN FINANCE, FALL 2013
SUPERVISOR: LAURENT BACH

An Investigation of Bargaining Power in
Mergers and Acquisitions

α β
Ivo Ivanov and Ralph Gohdes
December, 2013
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Abstract: In this paper we seek to investigate factors influencing
the bargaining position within merger negotiations. We take a step
back from agency theory and explore the source of bargaining
power rather than the management’s bargaining performance. In
doing so, we focus mainly on two factors: the product market
interactions between acquirer and target, and the method of
payment for the deal. First, we consider the effect of business
interdependencies in non-horizontal mergers, when targets and
acquirers are interdependent on each other as suppliers and
customers. Second, we study horizontal mergers where powerful
acquirers can leverage on their pricing strength to negotiate a
better deal. Third, we analyse the effect the method of payment
has within the context of bargaining power. Acknowledging the
market signalling effect of cash we extend current theories by
hypothesising that using cash as method of payment for the deal
provides acquirers with bargaining leverage and enables them to
negotiate a more favourable premium on the deal.
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Keywords: Mergers and acquisitions; Bargaining power; Industry interdependencies; Payment
method
Acknowledgements: We would like to thank our tutor, Laurent Bach, for his valuable comments
and continuous support throughout the research and writing process.

α Stockholm School of Economics,
An Investigation of Bargaining Power in Mergers and Acquisitions

Table of contents
1. Introduction ......................................................................................................... - 4 -
2. Literature review ................................................................................................. - 9 -
2.1 Product market interactions ............................................................................... - 9 -
2.2 Payment method .............................................................................................. - 10 -
3. Methodology & Data ......................................................................................... - 12 -
3.1. Data Selection .............................................................................................. - 12 -
3.2 Measure of merger gains ............................................................................. - 12 -
3.3 Identifying horizontal relationships ............................................................... - 15 -
3.4 Measure of horizontal relationship ............................................................... - 17 -
3.5 Measure of other factors affecting premiums and merger gains .................. - 18 -
3.6 Measure of vertical relationship .................................................................... - 19 -
3.7 Payment method .......................................................................................... - 21 -
3.8 Methodology................................................................................................. - 22 -
3.8.1 Analysis of non – horizontal industry dependencies .............................. - 22 -
3.8.2 Analysis of horizontal industry ............................................................... - 22 -
3.8.3 Payment method ................................................................................... - 23 -
4 Empirical Results .............................................................................................. - 23 -
4.1 Summary Statistics ...................................................................................... - 23 -
4.2 Non-horizontal mergers ................................................................................ - 26 -
4.3 Horizontal mergers ....................................................................................... - 29 -
4.3.1 Banking industry .................................................................................... - 29 -
4.3.2 Software industry ................................................................................... - 32 -
4.3.3 Oil, Mining and Utilities .......................................................................... - 33 -
4.3.4 Healthcare sector .................................................................................. - 33 -
4.3.5 Electronics manufacturing ..................................................................... - 34 -
4.3.6 Summary ............................................................................................... - 35 -
4.4 Payment Method – Cash versus Stock ........................................................ - 36 -
4.4.1 Non-horizontal mergers ......................................................................... - 36 -
4.4.2 Horizontal mergers ................................................................................ - 38 -
4.4.3 Summary ............................................................................................... - 40 -
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An Investigation of Bargaining Power in Mergers and Acquisitions

5 Limitations of the paper ................................................................................... - 40 -
6 Conclusion ........................................................................................................ - 41 -
7 References ........................................................................................................ - 43 -
A. Appendix ........................................................................................................... - 47 -

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An Investigation of Bargaining Power in Mergers and Acquisitions

Notes to the reader:
1. The paper does not aim at differentiating between a merger and an acquisition.
Therefore, we use the terms interchangeably.
2. All tables presenting regression results contain only an excerpt with the results of
the variables of interest. The complete tables with the results for all of the
variables in the regression are present in the appendix under the same name
and number.

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An Investigation of Bargaining Power in Mergers and Acquisitions

1. Introduction
The academic literature examining the effects of different factors on profitability of
mergers overall, as well as for the sell or buy side individually is extensive. However,
relatively few analyses consider the following two issues together: examination and
discussion of factors leading to the success or failure of one party in a transaction
(either the buy or the sell side separately) or the overall success of the deal on the one
hand, and determination and exploration of the factors that influence the relative
performance of one side in comparison to the opposing side. The second issue is, in
other word, the analysis of the relative bargaining ability of the respective sides in
determining which one will obtain a larger share of the anticipated added value
stemming from the transaction.
There has been much discussion, especially in agency theory, about factors
influencing managers’ drive to negotiate favourable deals for their respective
shareholders. Prior research has identified a causal link between ownership structure
and abnormal returns, in that target shareholders’ gains increased with managerial
ownership in the target company and decreased with institutional ownership (e.g. Stulz
et al., 1990, Moeller, 2005). Similarly, on the acquisition side, agency conflicts between
managers and owners are shown to result in strategically inferior matches since growth
generally appears to be more desirable to a manager than it is to the institution from the
point of view of its return on capital (Parvinen, Tikkanen, 2007). On a more general level
and in line with agency theory, research finds that managers with little or no ownership
not only tend to be less effective in negotiating on behalf of the shareholders but
typically actively pursue their own self-interest over the aims of the shareholders
(Hartzell, Ofek and Yermack, 2004).
Despite the extensive research on bargaining behaviour within merger
negotiations, we found that there is comparatively little research on the actual basis of
respective sides’ bargaining power. In other words, the leverage one side has over the
other due to its business relationships (or other factors), apart from the manager’s
motivation and drive to bargain within the bounds of the given circumstance. We believe
that the starting point i.e. the basis of the bargaining position should be more crucial
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An Investigation of Bargaining Power in Mergers and Acquisitions

than the manager’s drive to utilise the leverage presented to him. Consequently, we
believe that this field of research is significantly underrepresented in academic literature
so far. In this paper we would, therefore, like to shift the focus away from agency theory
and explore several factors from a different perspective which we believe should have a
significant effect in the bargaining process of an acquisition.
First, we re-evaluate the relationship between a target’s ability to capture a larger
share of projected merger gains and its product market interaction with its acquirer,
initially proposed by Ahern (2009). More precisely, in the case of horizontal mergers, the
leverage the acquirer has, due to posing a credible and significant threat of perusing a
predatory pricing strategy if the target’s management should fight a merger. Similarly, in
the case of vertical mergers, the leverage one firm has over the other by threatening to
end or reduce an existing business relationship (or the opportunity cost of foregoing on
the possibility of such) if the deal should not find the desired end. For instance,
acquirers, which are highly dependent on targets as key suppliers, will restrain from
aggressive bargaining in order not to damage the existing business relationship.
Therefore, our premise is that a firm’s bargaining position is determined by the leverage
gained through existing real and perceived commercial interdependencies or
vulnerabilities.
Hypothesis 1: The credible threat of a possible price war increases the
bargaining power of the acquirer and decreases that of the target. – The market
pressure hypothesis
Hypothesis 2: There is a causal link running from the business
interdependencies between acquirer and target to the bargaining power of both firms in
the merger process. – The business interdependency hypothesis
In this paper we modify the approach Ahern has undertaken in two main aspects.
First, we use a different method to classify whether mergers are horizontal or non-
1
horizontal by employing a new industry classification system (TNIC ) develope d by
Hoberg and Philips (2011), which allows us to identify for each company a personal ised

1
TNIC – acronym for text-based network industry classifications
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An Investigation of Bargaining Power in Mergers and Acquisitions

2
set of direct competitors based on the product descriptions given in its 10-K reports,
thereby being more precise than previous classification methods. T o the best of our
knowledge this is the first paper to apply the TNIC industry classification in this context.
Secondly, we identify a weakness in Ahern ’s horizontal deal analysis where he
uses the highly industry specific variables such as market share and return on assets
(RoA) to proxy for the pricing power and the financial strength of each firm involved in
the acquisition process. The main issue here is that his horizontal analysis involves
M&A deals in various industries which are characterized by different market conditions
and profitability benchmarks. For instance, the return on assets of a target in the
services industry is directly compared to that of a target in the manufacturing sector.
This general approach is unreasonable and can provide misleading results. In order to
solve this issue, we separately investigate the merger activity among several industry
sectors (i.e. banking, software development, oil, mining & utilities, healthcare and
electronics manufacturing). We argue that this industry clustering approach is more
suitable for the analysis of bargaining power in horizontal deals since the merger
samples will contain deals from the same industry. Consequently, the usage of RoA is
comparable among targets and acquirers in different mergers from the same industry
and can serve as a proxy for the financial strength of each firm. By analysing horizontal
acquisitions in the same industries we mitigate the market specificities problems evident
in Ahern’s approach.
In line with Ahern (2009) we report that larger targets with respect to the acquirer
in terms of market value tend to capture a higher premium and a larger share of the
abnormal dollar merger gains around the announcement date. Moreover, the result
seems to be evident in all of the five industries we have considered. Nevertheless, our
findings do not seem to be very conclusive in support of the market pressure
hypothesis. With respect to the business interdependency hypothesis, we do not find
conclusive robust empirical evidence in line with the findings of Ahern (2009).

2
K10 report – standardised information required by the SEC for stock market participants
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An Investigation of Bargaining Power in Mergers and Acquisitions

In addition to the product market interactions between a target and an acquirer
we investigate the form of payment in a deal (i.e. cash or stock), which we believe to
also have a significant effect over the bargaining process in acquisitions.
The payment method, in particular cash versus stock, may influence the
bargaining process due to uncertainty and information asymmetry issues regarding the
acquirer’s and target’s true value. According to Fuller, Netter & Stegemoller (2002) each
firm (naturally) has a superior understanding of its own (over- or under-) valuation and
hence can exploit this in using the method of payment accordingly. The information
asymmetry aspects arising in this situation have also given rise to theories about the
signalling effect when the acquirer decides to use stock as a form of payment. Several
studies including Myer and Majluf (1984), Fishman (1989) and Hansen (1987) argue
that using stock exclusively as a payment method to acquire a company can indicate
that the acquirer estimates its own shares to be overvalued. Alternatively, a cash
payment can hint the opposite – a possibility that the market undervalues the shares of
the bidding firm.
In this paper we thus explore a further hypothesis linking the payment method
with the bargaining process. We argue that from a target’s point of view cash would be
a preferred method of payment since it mitigates the uncertainty regarding the fair
valuation of the acquirer’s stock. Our assumption is that a target’s management board
would settle for a lower premium if the acquirer offers cash as a payment method for the
deal. Looking at the buy side of the deal we identify two effects related to the choice of
payment. On the one hand, a cash payment may be interpreted as a signal that the
acquirer was able to achieve a better price for the deal if the causal relationship
described above were to hold. On the other hand, acquirers experience the same
uncertainty issues with the valuation of the target and consequently might be less willing
to use cash exclusively as a payment method. Thus, if the acquirer chooses to pay in
cash this would tend to decrease the transaction value of the deal. In essence, the
choice of payment can provide a significant leverage in the bargaining process.
We further argue that the effect of cash or stock as payment method is different
for horizontal than it is for non-horizontal mergers. A simple share exchange as a form
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An Investigation of Bargaining Power in Mergers and Acquisitions

of payment can provide an incentive for the shareholders of the acquired company to
ensure the success of the merger since their payoff depends on the value of the shares
of the combined company. We reason that in horizontal mergers, the acquirer typically
has more knowledge about the target and its operations since both companies operate
in the same industry and are direct competitors. Therefore, in a horizontal merger, the
acquirer will usually be less dependent on the participation of the target’s management
board and shareholders in order to enable an effective merger integration. In contrast, in
non-horizontal mergers, which include both vertical and diversifying mergers, the
acquirers will typically be more dependent on the participation of the target’s
shareholders and management board to ensure a successful merger since the bidding
firm will generally have less insight into the business and operations of the target.
Consequently, our argument is that in non-horizontal deals acquirers are more prone to
use stock as payment for the deal. In turn, this means that if the acquirer decides to use
cash they will pay a much lower premium. In essence the effect of payment method on
the bargaining process should be larger in non-horizontal deals than it should in
horizontal mergers.
Hypothesis 3: The acquirer would pay less for the acquired company if it offers
cash instead of stock as payment method. The effect should be more evident in non-
horizontal deals. – The payment method hypothesis
Our empirical findings suggest that targets capture less of the abnormal dollar
merger gains when the payment is in cash. However, the effect seems to be relatively
stronger for horizontal acquisitions than it is for non-horizontal mergers. Furthermore,
there is no statistically significant effect on the acquisition premiums.
Following this introduction our paper is organized as follows. Section 2 presents
a review of academic literature. Section 3 goes on to describe the data and the
empirical methods used in the paper. Section 4 presents the empirical results of the
analysis. In section 5 we discuss possible limitations and criticism of the paper. In
closing, section 6 summarizes the results, concludes the paper and outlines ideas for
further research into the topic.
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An Investigation of Bargaining Power in Mergers and Acquisitions

2. Literature review
2.1 PRODUCT MARKET INTERACTIONS
The effect business interdependencies have on business partners’ bargaining positions
has been previously examined in a different context, namely in incomplete contract
theory. In the case of a business relationship that depends on one side to undertake a
relationship-specific investment, the value of which is highly dependent on that
relationship (i.e. loosing significant value outside that relationship), the party
undertaking that relationship-specific investment will encounter a loss in bargaining
power, as the opposing side can post-investment opportunistically renegotiate the terms
of the original agreement, in a context where contracts cannot be made to a sufficiently
specific level (Klein, Crawford, and Alchian, 1978). This effect can make business
relationships unattractive to a point where they are no longer undertaken. The
weakening of the bargaining position of one party after the dependency on another
party can, in fact, be so harmful to the first party that a merger or acquisition may
become the best solution to overcome the outlined problem of mistrust, incomplete
information and insufficiently accurate contracts (Graebner, 2009). This effect of mutual
dependency illustrated above shows that high business dependencies on the part of
one party relative to another are synonymous with a weak bargaining position.
Fan and Goyal (2006) first employ the Input-Output tables published by the US
department of Commerce: “Bureau of Economic Analysis” (BEA) to distinguish between
vertical and diversifying mergers also used in our paper. They find an increase of
vertical merger activities in the years after 1980 by studying a time period between 1962
and 1996. Furthermore, Fan and Goyal (2006) argue that vertical mergers achieve a
comparable wealth effect to horizontal mergers and a significantly higher wealth effect
than diversifying mergers. In vertical acquisitions, Ahern (2009) finds a positive
relationship between the premium paid to the target and the acquirer’s dependence on
the target’s input. An inversely proportionate relationship is found between the premium
paid by the acquirer and the target’s dependency on the acquirer’s input. Furthermore, a
3
larger toehold reduces premiums and target leverage increases premiums. Firm market

3
Toehold purchase is the purchase of less than 5% of a firm’s outstanding stock by an acquirer.
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